Markets and Prices

PRINT

On this page:

Definitions and Basics

    Supply and Demand. Part 2. Comparisons on Price, at SocialStudiesforKids.com.
    So we have supply, which is how much of something you have, and demand, which is how much of something people want. Put the two together, and you have supply and demand.

    Now, how do you show the relationship between the two? One way is to use the price of something. Generally speaking, the price of something will go up if the demand goes up. Why? Because the seller thinks he or she can get more money for whatever he or she is selling....
    Microeconomics, from the Concise Encyclopedia of Economics
    At the root of everything is supply and demand. It is not at all farfetched to think of these as basically human characteristics. If human beings are not going to be totally self-sufficient, they will end up producing certain things that they trade in order to fulfill their demands for other things. The specialization of production and the institutions of trade, commerce, and markets long antedated the science of economics. Indeed, one can fairly say that from the very outset the science of economics entailed the study of the market forms that arose quite naturally (and without any help from economists) out of human behavior. People specialize in what they think they can do best--or more existentially, in what heredity, environment, fate, and their own volition have brought them to do. They trade their services and/or the products of their specialization for those produced by others. Markets evolve to organize this sort of trading, and money evolves to act as a generalized unit of account and to make barter unnecessary.
    Demand and Supply, by Dwight Lee. At CommonSenseEconomics.com. Also available: audio.
    The Basics of Demand and Supply: Although a complete discussion of demand and supply curves has to consider a number of complexities and qualifications, the essential notions behind these curves are straightforward. The demand curve is based on the observation that the lower the price of a product, the more of it people will demand. There may be occasional exceptions to this behavior (and indeed economists have developed the theoretical possibility of such an exception), but they are so few and transient that economists refer to the negative relationship between price and quantity demanded as the "law of demand." Because of the law of demand, demand curves (such as D in the figure) are always shown as downward sloping, with the price on the vertical axis and the quantity demanded (over some period) on the horizontal axis.

    The basic notion behind the supply curve is that the higher the price of a product, the more of it producers will supply. In other words, as with the curve S in the figure, supply curves are upward sloping. A justification for this upward-sloping relationship between price and quantity supplied is that the cost of producing additional units of the product increases as more is produced. So it takes a higher price to motivate additional output. But this is not necessarily the case when there is time for new firms to enter an industry, or for existing firms to expand their plant size. Such long-run adjustments to a higher price can permit more of the product to be made available at the original cost (or even a lower cost), in which case the supply is horizontal (or negatively sloped). But over periods of time that can extend to several months or more, it is reasonable to assume that supply curves slope upward....
    Market Clearing, from Amosweb.com's Gloss-orama.
    The price and quantity that equates the quantity demanded and quantity supplied; equates the demand price and supply price; and achieves market equilibrium. In other words, the market is "cleared" of shortages and surpluses.
    Supply, from the Concise Encyclopedia of Economics
    One function of markets is to find "equilibrium" prices that balance the supplies of and demands for goods and services. An equilibrium price (also known as a "market-clearing" price) is one at which each producer can sell all he wants to produce and each consumer can buy all he demands. Naturally, producers always would like to charge higher prices. But even if they have no competitors, they are limited by the law of demand: if producers insist on a higher price, consumers will buy fewer units. The law of supply puts a similar limit on consumers. They always would prefer to pay a lower price than the current one. But if they successfully insist on paying less (say, through price controls), suppliers will produce less and some demand will go unsatisfied....
    Efficiency, Supply and Demand, and Market Clearing, by Arnold Kling
    Supply and Demand: Prices play a central role in the efficiency story. Producers and consumers rely on prices as signals of the cost of making substitution decisions at the margin. How are prices determined?

    Economic theory says that the price of something will tend toward a point where the quantity demanded is equal to the quantity supplied. This price is known as the market-clearing price, because it "clears away" any excess supply or excess demand.

    Market clearing is based on the famous law of supply and demand. As the price of a good goes up, consumers demand less of it and more supply enters the market. If the price is too high, the supply will be greater than demand, and producers will be stuck with the excess. Conversely, as the price of a good goes down, consumers demand more of it and less supply enters the market. If the price is too low, demand will exceed supply, and some consumers will be unable to obtain as much as they would like at that price—we say that supply is rationed....

In the News and Examples

    McKenzie on Prices. Podcast. EconTalk, June 23, 2008.
    Richard McKenzie of the University California, Irvine and the author of Why Popcorn Costs So Much at the Movies and Other Pricing Puzzles, talks with EconTalk host Russ Roberts about a wide range of pricing puzzles. They discuss why Southern California experiences frequent water crises, why price falls after Christmas, why popcorn seems so expensive at the movies, and the economics of price discrimination.
    Robert Frank on Economics Education and the Economic Naturalist. Podcast. EconTalk, October 15, 2007.
    Author Robert Frank of Cornell University talks about economic education and his recent book, The Economic Naturalist. Frank argues that the traditional way of teaching economics via graphs and equations often fails to make any impression on students. In this conversation with host Russ Roberts, Frank outlines an alternative approach from his new book, where students find interesting questions and enigmas from everyday life. They then try to explain them using the economic way of thinking. Frank and Roberts discuss a number of the enigmas and speculate on the future of economics and education. The topics discussed include tuxedos vs. wedding dresses, the level of civility (or lack thereof) in New York City, the difference between vending machines for soda and newspapers, the tragedy of the commons, and the economics of love.
    Ticket Prices and Scalping. Podcast. EconTalk, July 16, 2007.
    EconTalk host Russ Roberts talks about scalping and visits AT&T Park hours before Major League Baseball's All-Star Game to talk with a scalper, a merchandiser, a fan, and the police about prices, tickets, baseball and the law.
    Don Boudreaux on Energy Prices. Podcast. EconTalk, Aug. 25, 2008.
    Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about the recent surge in energy prices. They talk about why prices have risen, the implications for America's standard of living and the implications for public policy.
    Roberts on the Price of Everything. Podcast. EconTalk, Aug. 25, 2008.
    Russ Roberts, host of EconTalk and author of the economics novel, The Price of Everything, talks with guest host Arnold Kling about the ideas in The Price of Everything: price gouging, the role of prices in the aftermath of natural disaster, spontaneous order, and the hidden harmony of the economic cosmos. Along the way, Roberts talks about novels vs. textbooks and other traditional treatments of economic reasoning.
    Should everything be traded in markets? Cowen on Liberty, Art, Food and Everything Else in Between. Podcast at EconTalk
    0:38-7:41 Intro, books by Cowen. A listener asked: What are the limits of libertarianism, or perhaps the limits of markets? Cowen's "Markets in Everything" posts at MarginalRevolution.com touch on moral and legal codes, politics and voting--not everything should be bought and sold in markets. Zelizer podcast. "Markets take on their meaning because not everything is a market." "What happens when you reject the Aristotelian ideal of moderation?" CDs, iTunes example....
    Cole on the Market for New Cars. Podcast. EconTalk, June 09, 2008.
    Steve Cole, the Sales Manager at Ourisman Honda of Laurel in Laurel, Maryland talks with EconTalk host Russ Roberts about the strange world of new car pricing. They talk about dealer markup, the role of information and the internet in bringing prices down, why haggling persists, how sales people are compensated, and the gray areas of buyer and seller integrity.

A Little History: Primary Sources and References

    Leon Walras, biography from the Concise Encyclopedia of Economics
    ... Walras's biggest contribution was in what is now called general equilibrium theory. Before Walras, economists had made little attempt to show how a whole economy with many goods fits together and reaches an equilibrium....

    ... Walras was aware that the mere fact that such a system of equations could be solved mathematically for an equilibrium did not mean that in the real world it would ever reach that equilibrium. So Walras's second major step was to simulate an artificial market process that would get the system to equilibrium, a process he called "tatonnement" (French for "groping"). Tatonnement was a trial-and-error process in which a price was called out and people in the market said how much they were willing to demand and supply at that price. If there was an excess of supply over demand, then the price would be lowered so that less would be supplied and more would be demanded. Thus would the prices "grope" toward equilibrium.
    Alfred Marshall, biography from the Concise Encyclopedia of Economics
    Alfred Marshall was the dominant figure in British economics (itself dominant in world economics) from about 1890 until his death in 1924. His specialty was microeconomics--the study of individual markets and industries, as opposed to the study of the whole economy. In his most important book, Principles of Economics, Marshall emphasized that the price and output of a good are determined by both supply and demand: the two curves are like scissor blades that intersect at equilibrium. Modern economists trying to understand why the price of a good changes still start by looking for factors that may have shifted demand or supply, an approach they owe to Marshall....
    Equilibrium of Normal Demand and Supply, by Alfred Marshall. Book V, Chapter 3 in Principles of Economics
    We have next to inquire what causes govern supply prices, that is prices which dealers are willing to accept for different amounts....

    When demand and supply are in stable equilibrium, if any accident should move the scale of production from its equilibrium position, there will be instantly brought into play forces tending to push it back to that position; just as, if a stone hanging by a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position. The movements of the scale of production about its position of equilibrium will be of a somewhat similar kind*19. [par. V.III.21. See footnote 19 for the original diagram of supply and demand.]

Advanced Resources

    Classroom experiments with supply, demand, and equilibrium. Vernon Smith on Markets and Experimental Economics. Podcast. EconTalk, May 21, 2007. Includes printable Listening Guide.
    Vernon Smith, Professor of Economics at George Mason University and the 2002 Nobel Laureate in Economics, talks about experimental economics, markets, risk, behavioral economics and the evolution of his career.
    Vernon Smith on Markets and Experimental Economics. Podcast. EconTalk, Mar. 3, 2008.
    Nobel Laureate Vernon Smith of Chapman University and George Mason University talks with EconTalk host Russ Roberts about the ideas in his new book, Rationality in Economics: Constructivist and Ecological Forms. They discuss the social and human sides of exchange, the robust nature of equilibrium in experiments and the real world, the seeming contradiction between Adam Smith's two great works, the unpredictability of how innovation emerges and its rationality, what neuroscience might tell us about economic decision-making, and the challenges of small-group intimate exchange and our interactions with strangers in the extended order of the marketplace.

Related Topics